November 2008

ELECTRONIC TRADING: Sparks are flying

Nicholas Pratt looks at how competition is shaking up algorithmic trading and direct market access between older and new exchanges ... Alternative stock exchanges – the so-called multilateral trading facilities (MTFs) like Chi-X and Turquoise – are challenging older exchanges. A recent report from research firm Tabb Group, European Equity Market Structure: Liquidity, Trust and Competition, says that as older exchanges “seek to maintain their positions of strength, they will increasingly adopt the traits of their competitors in terms of technology, access, fee structure and trading functions”.

The London Stock Exchange (LSE) has recently announced a restructuring of its tariff designed to appeal to those firms engaged in algorithmic trading.

“The new tariff was carefully designed to lower direct costs, but it also aims to reduce the overall cost of trading for everyone by encouraging and rewarding liquidity provision,” says Martin Graham, director of equity markets at the LSE. The new tariff is also aligned with the way that the LSE’s member firms charge their own customers, says Graham, meaning that whether investors benefit from these changes will depend on how their brokers pass the cost reductions onto them.

The LSE has also tried to enhance its direct market access (DMA) offering, says Graham, in order to benefit those buy-side firms engaged in high frequency and often complex trading strategies.

“All of the work that we have done on capacity and latency has been very important for them,” says Graham. “We are also looking at measures to bring latency down further, with a reduction to three milliseconds end-to-end latency this autumn being the next target, and we have also introduced a hosting service which will enable very latency-sensitive users to host their servers right next to our trading platform and get sub-millisecond access.”

Product innovations
The LSE is also planning further product innovations, says Graham, including an order book that combines equities and contracts for difference (CFDs) and the introduction of a central counterparty for its International Order Book. In 2009 the LSE will be introducing a FIX interface for its TradElect platform and a FAST interface for its data service Infolect. And it is also currently developing its own dark pool, called Baikal, aimed at enabling “institutional-sized” trades to be made in what is a fragmented European marketplace.

Meanwhile NYSE Euronext, the US-European exchange that operates the Paris, Brussels, Lisbon and Amsterdam exchanges, has sought to compete with the new entrants by launching its own MTF for trading pan-European blue-chip stocks. According to Cees Vermaas, executive director, European sales at NYSE Euronext, the MTF will be the most powerful platform in Europe and will “complement both our existing market and the block trading facility SmartPool”.

One exchange that has been a relatively early mover in terms of its adoption of new trading models is the Switzerland-based SWX, operated by the Swiss Exchange.

In the past year it has begun three major developments, says managing director Lee Hodgkinson, which include the restructuring of its tariffs, the launch of a dark pool in partnership with US-based dark pool developer NYFIX and it is currently in the process of overhauling its technology to increase capacity and decrease latency. “It is quite an aggressive plan of change,” says Hodgkinson.
Hodgkinson is doubtful that the market will be able to cope with so much change and innovation in the exchange landscape, should all other incumbent exchanges look to replicate the new developments. “I suspect it will not have the capacity to deal with it all in 2009, which vindicates our strategy to be aggressive early on and puts us in a strong position now,” he says.

But will the market’s lack of capacity to deal with change also be accompanied by the market’s lack of appetite to participate in new ventures? “I think that anyone that has seen new innovations delivered in the last couple of months would have been happier having launched them in more buoyant times,” says Hodgkinson. “However, the SWX has been around for a long time and we plan on being around for a long time to come. We think dark trading will be a long-term success. It may be a more slow-burning success due to the current market conditions, but I don’t think there is any reason to panic.”

New market entrants
Hodgkinson adds that the need to remain calm also extends to the new entrants to the market, even if the next year could be challenging given that many of them are seeing volume generated by proprietary trading which is often dependent on the availability of credit. Additionally, many of the new entrants have aggressive business plans but do not operate in necessarily high margin areas, says Hodgkinson. “So if they need to undergo another round of funding in the next six to nine months, it will be harder than it was six to nine months previously.”

Despite the fact that all the incumbent exchanges have introduced significantly reduced tariffs and are adopting many of the characteristics of rival execution venues by launching their own dark pools, CFDs, MTFs and low latency feeds, there is still a reluctance to explicitly state that these changes are the result of new, MiFID-inspired entrants. “We have always lived in a competitive environment and we have always looked to continually develop our systems,” says Rainer Riess, managing director, cash market development, Deutsche Börse. “The last year has been more about listening to our customers than about new competitors.”

In the last twelve months Deutsche Börse has revised its tariffs and introduced a new clearing service, moved 300,000 structured products onto its trading platform and also developed a fund trading service for 3,500 mutual funds as well as undergoing the seemingly obligatory enhancement of its technology to increase capacity and decrease latency.

Like Hodgkinson, Riess also feels that the current financial crisis should have little effect on the established exchanges such as Deutsche Börse. “We normally have two major releases a year in terms of new technology or new services and I think we will keep that up next year,” he says. MiFID may have opened the doors for new competitors, but the current financial crisis could yet see the momentum swing back to the incumbent exchanges. “Next year will see changes in terms of the availability of technology and the increased importance of risk management, which is an area we excel in,” says Riess.

No viable alternative
The image of the incumbent exchanges as bastions of stability and operational resilience was dented somewhat in September when the LSE’s TradElect system went down for seven hours during what was a particularly busy Monday. However, Graham says that the incident served to underline just how dependent the market is on the likes of the LSE, rather than its new rivals, as the primary source of liquidity. “It is certainly striking that while our trading platform was not available, other venues did not provide a viable alternative price formation mechanism with wide spreads and thin trading,” says Graham. He also refers to the increase in market share that the LSE enjoyed following the default of Lehman Brothers and the takeover of HBOS by Lloyds TSB.

“This suggests that where there is uncertainty or volatility, traders will look to the most liquid market and the tightest spreads,” says Graham, who adds that the Lehman’s default also highlighted the benefit of centrally traded and cleared markets with well-defined rules and procedures and is likely to signal a shift away from OTC trading back to regulated markets. 

While the recognition of regulated markets is to be welcomed, thefear is that this return to familiarity may also signal some reticence and inertia from fund managers that were considering investing in the technology and tools neededto take a deeper involvement in their own trading but may now decide against such a move. This would be a mistake, says Hodgkinson, among others, not least because it is now clear that the incumbent exchanges have recognised that the new entrants are not going to disappear overnight and they are going to have to make their own services more appealing to investorsand traders.

“Yes the world looks verydifferent to how it did three to four months ago,” says Hodgkinson. “But if fund managers are willingto be entrepreneurial and willing to invest in technology, they can do well because everyone is fighting for their attention and their business.” ©2008 funds europe

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